Relieving the Pain of Dividend Growth Investors

By Torsten Tiedt

Dividend growth investing is a pain, because it is much more difficult to find solid dividend growth stocks than it should be.

In this guest article, I'll explain why I think finding solid dividend growth stocks is harder than it should be and how I tackled this problem for me (and for you!).

A dividend growth investor wants to buy stocks with increasing dividends each year. But how do you find such stocks? Thanks to the internet, you can find countless tools to help you. But the sheer number of these tools is quite intimidating! Furthermore, it seems nearly impossible to rely on just one tool.

Consider DivGro's approach. To analyze his ten top-ranked stocks of the month, he uses:

• The CCC spreadsheet
• Morningstar
• S&P Capital IQ
• F.A.S.T. Graphs
• Finbox.io, and
• Simply Safe Dividends

For dividend enthusiasts ready to invest time and money into these tools, this could be the way to go.

But for ordinary men or women, it would be overkill to use a half-dozen tools and pay the subscription fees only to find a handful of stocks to buy.

Why is finding solid dividend growth stocks so difficult?

To find the answer, let’s understand what you are really looking for. The quest for safe and rising dividends means that you are looking for dividend-paying companies with stable or, even better, rising profits. No profits, no dividends! At least not in the long run.

How to find companies with rising profits

One way to measure profitability is to use ordinary measures like the PE ratio or the payout ratio. These measures calculate a ratio using the earnings of a single year. I call these static measures and, in my view, static measures suck! They suck because they are only snapshots. It’s like measuring an athlete’s time for only 100 meters when running a marathon. Even a crippled stock may have an attractive looking PE ratio after the share price dropped. And after a dividend cut, the payout ratio of a stock could look fine.

Another way to assess profitability is to rely on analysts. While this looks like an easy way to go, it has downsides because you have to rely upon and trust the opinions of others. It is like they're creating a black box that you can't peek into! If you don't understand the reasons for a particular recommendation, panic could set in if the trade goes against you or if the market crashes.

Typically, analysts rely on static measures, too. They consider quarterly reports and compare results to prior and year-ago quarters. Static measures are not good enough! We need dynamic measures that consider earnings results over periods of five, ten, or even twenty years!

A better way

In a casino, playing red on a roulette wheel ten times in a row doesn’t help you to predict what’s coming next. But a company with increasing profits ten times a row has a significantly higher chance of doing so next year compared to a company with a mixed earnings history.

In a competitive environment, generating profits requires effort – it doesn't come coincidentally.
Turning profits ten years in a row is the financial manifest of an excellent business model, along with sound business processes, capable management, and strong brands combined with market power.

Consider a common measure of long-term growth, the compound annual growth rate (CAGR) that quantifies the average growth over a given period. Looking at the CAGR is not enough. A mixed profit history with ups and downs will dramatically change the growth rates each year.

Here's an example showing the five-year earnings growth rates of AT&T (T) starting from 2010 and 2011:
Isolated calculation of growth rates is not meaningful for companies with highly volatile profits. Furthermore, dividend growth investors should avoid companies with highly volatile profits, because their dividends probably are not safe.

The volatility of profits can be quantified using correlations. In our case, correlation measures the relationship between profit and time. The result goes from +1.0 to -1.0. A result of 1.0 means a perfect correlation between profit and time, like a straight line drawn with a ruler. If the line slopes upwards (our preference), the 1.0 is positive. If it slopes downwards, we have -1.0. A zero means there is no correlation between profit and time.

In reality, profits are not perfectly correlated with time. Profits behave like a wave going up and down in time. For example, the earnings correlation of 3M (MMM) is +0.97:
Contrast that with the earnings correlation of AT&T, which is +0.03, meaning the company does not manage to increase its profits:

Conventional stock screeners fail

With this knowledge, look at the stock screeners you know about or use. What do they offer that helps you find high-quality stocks? As far as I have seen, conventional stock screeners do not offer dynamic measures or ways to quantify the volatility of profits. They fail in this regard.

For these reasons, I've developed my own screener that combines growth rates, correlations, and other dynamic measures to screen for high-quality dividend growth stocks.

To give you an idea how the screener works, let’s examine DivGro’s 10 Dividend Growth Stocks For January 2018” in the screener:
Source: https://dividendstocks.cash

The stocks are sorted by correlation of profits called earnings stability (1). Notice, that DivGro selected stocks with high numbers close to the maximum value of +1.0. I consider values of 0.8 and above as very high quality.

In (2), the earning’s growth rates are shown. DivGro selected stocks with sound (> 5%) to high growth rates (> 10%). Red numbers mean that earnings growth slowed down the last five years.

The next columns (3) and (4) apply the same logic to dividends.

Dividend growth investors typically choose stocks from an elite group of stocks deemed to offer very high dividend stability. One such proxy for dividend stability is the select group of 53 S&P 500 stocks with 25+ years of consecutive dividend increases, called the Dividend Aristocrats.

However, they rarely consider earnings stability, because there is not a similar proxy for earnings stability. I believe it is crucially important also to consider earnings stability when selecting dividend growth stocks. Dividend stability depends on earnings stability, especially long-term.

Conclusion

In this article, I tried to show how difficult it is to find high-quality dividend growth stocks, especially if you only use static measures like PE and payout ratios. I presented my solution and shared an example of the dividend screener I developed based on dynamic measures of quality, including earnings and dividend stability.

There is much more to write on this topic! If you are interested in reading more, please leave a comment and I will gladly reply and share more information!

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This article was written by Torsten Tiedt, founder of DividendStocks.Cash.  Torsten is a senior developer in the investment industry in Frankfurt, Germany.  His expertise was used during the liquidation of Lehman Brothers as well as in the
first banking stress test of the European Central Bank. 

DividendStocks.Cash is a stock screener dedicated to long-term dividend growth investment.
Dynamic key figures are calculated using 20+ years of a company's financial history.
Interactive charts make the growth of earnings, dividends, and cash-flow visible at a glance. DividendStocks.Cash offers various fair value estimates to determine
if a stock is trading at a premium or at a discount.